Wall Street Profits by Putting Investors in the Slow Lane

Wall Street has developed a new way, clouded in obscurity, to fleece the hundreds of millions of Americans who have money invested in company pension plans, mutual funds and insurance policies.

Institutional brokers are legally obliged to execute trades on the exchange that offers the most favorable terms for their clients, including the best price and likelihood of executing the trade. The 12 exchanges, most of which are owned by New York Stock Exchange, Nasdaq and Better Alternative Trade System (BATS), along with the Chicago Stock Exchange and the Investors Exchange (IEX), are supposed to compete to offer the best opportunities.

But that’s not what is happening. Instead, brokers routinely take kickbacks, euphemistically referred to as “rebates,” for routing orders to a particular exchange. As a result, the brokers produce worse outcomes for their institutional investor clients — and therefore, for individual pension beneficiaries, mutual fund investors and insurance policy holders — and ill-gotten gains for the brokers.

Although the harm suffered on each trade is minuscule — fractions of a cent per share — the aggregate kickbacks amount to billions of dollars a year. The diffuse harm to individuals and the concentrated benefit to Wall Street create yet another way in which the system is rigged, justifiably eroding public confidence in the fairness of the financial system.

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The IEX trading floor in Manhattan in 2016.CreditCole Wilson for The New York Times

This is how it works: The likelihood of executing a trade at the best price depends on the length of the queue to buy or sell and the incentives to trade. Longer queues lead to longer delays to execute a trade. Delays typically lead to worse outcomes. Quite simply, it makes no sense to wait on a longer line to receive a worse execution.

And yet, brokers choose longer queues hundreds of thousands, if not millions, of times a day. Publicly available trade and quote data show that the queues to buy or sell stock are considerably longer on exchanges that offer kickbacks. Even though the queues decrease the likelihood of getting a trade completed and impair the price performance after the trade is executed, brokers still direct trades to these places because of the kickbacks they receive.

One exchange, the IEX, refuses to pay rebates. Created by Brad Katsuyama (whose odyssey to defy the ethos of Wall Street was told in Michael Lewis’s “Flash Boys”), IEX has a speed bump that prevents high-frequency traders from front-running ordinary investors. (Yale University, where we work, has a de minimis exposure to IEX through an investment by one of the university’s external managers.)

Since opening on Aug. 19, 2016, IEX has delivered on its promise of better execution. Consider data on effective spread, which measures an exchange’s ability to provide trade executions at attractive prices. A lower effective spread is good for investors, since the gap between what buyers pay and what sellers receive is smaller.

BATS (a rival stock exchange founded by a high-frequency trader) posts data on this measure of execution quality for the major exchanges on its website. According to our calculations, in the six months before IEX’s arrival, Nasdaq led the effective spread rankings in the widely used Standard & Poor’s 500 index, with the number of top ranks ranging from 169 to 216 stocks.

In September 2016, IEX’s first full month of operation, the exchange crushed its rivals, offering the best effective spread for 412 of the S.&P. 500’s stocks. In the ensuing months, IEX’s dominance increased, with the exchange displaying the lowest effective spread for 497 of the stocks in the S&P 500 in May 2017 and for 500 stocks in June 2017. (In June, the S&P 500 actually contained 505 stocks.)

The added cost to investors trading on other exchanges is stunning. On average, the competing exchanges have effective spreads 96 percent higher than IEX’s for stocks in the S.&P. 500, with the premium ranging from 80 percent to 158 percent on the exchanges for which BATS provided data.

The obvious question in light of IEX’s superior execution quality is why the exchange has a market share of just over 2 percent. One reason seems obvious: Unlike the other exchanges with greater market share, IEX does not pay broker kickbacks. (BATS and the New York Exchange have each recently converted one of their exchanges to a kickback-free model.)

Elimination of kickbacks would elevate the integrity and quality of America’s securities markets, improving executions for real investors and restoring a sense of fairness. Since kickbacks result in worse trade execution, brokers that route client orders for kickbacks violate their duty of best execution.

Senator Mark Warner, a member of a Senate subcommittee on banking and investment, recognizes the conflict created by the practice of paying rebates. On July 14, Senator Warner wrote to SEC Chairman Jay Clayton urging the full elimination of rebates to “increase price transparency, reduce fragmentation, strengthen stability, and bring U.S. equity markets” closer to the competitive mandate.

Maybe it’s time for the Securities and Exchange Commission to start enforcing its own best-execution rule.

Jonathan Macey is a professor at Yale Law School. David Swensen is the chief investment officer of Yale University.